Understanding Mortgage Spreads

Abstract

Agency mortgage-backed securities (MBS), which carry essentially no credit risk from the point of view of investors, nevertheless often trade at significant spreads to other credit-risk free instruments, even after accounting for the prepayment option embedded in MBS. In this paper, we argue that “prepayment model risk” is a potentially important driver of MBS spreads, and propose and implement a method to isolate its contribution to spreads. We find that this risk indeed helps explain crosssectional patterns in spreads, while time series variation is mostly explained by other factors. We also use our decomposition to understand spread movements around the initial announcement of the Federal Reserve’s MBS purchase program. (With Andreas Fuster and David O. Lucca)